When transactions costs collapse and competition becomes ‘perfect’: the column

In physics we’re used to the idea that at different scales and at different stages of some process, very different things happen. We inhabit Newton’s world of medium sized things and speeds – planets, trees, footballs and travel at walking, driving or flying speed – even space station speed. When things get very big or fast – intergalactic or close to the speed of light – very strange things happen that defy our own intuitions. And inside atoms when things get even weirder. Likewise during a ‘phase transition’ of some matter from one phase to another – from solid to liquid for instance – strange and counterintuitive things happen.

Well something slightly similar has happened on the internet where transactions costs have fallen to near zero. And strange and fascinating things are happening. Anyway, I’ve been mulling over this for a while now, and verily, along comes this compelling OECD study of the internet. So I’ve written it up in this week’s column in the Age and SMH.

ECONOMISTS usually hate monopoly. But one of last century’s most flamboyant economists – Austrian finance minister turned Harvard professor, Joseph Schumpeter – thought it indispensable to economic progress.

Here’s his argument: Companies innovate to capture some fleeting market power with innovation until their competitors catch up. But they can’t innovate without funding research and development. And doing that requires them to use what monopoly or market power they have by raising prices above production costs.

In economists’ models, ”perfect competition” involves a multitude of companies disciplining each other so all are forced to take the price at which any are prepared to sell – the cost of production. But Schumpeter argued that this wasn’t just an unearthly ideal type that can never exist (in economists’ models, perfect competitors all exist in a timeless steady state with identical skills, technology and expectations). He argued that, even if it were possible it wasn’t desirable, because perfect competitors are so busy competing they have no margin to fund innovation.

If Schumpeter showed us the upside of monopoly, there is (alas), a mighty downside. Even if they’ve won their position from past innovation, even if they’re competing against others, large incumbent companies often become conservative and lazy.

Where fixed R&D costs are high enough – in pharmaceutical innovation for instance – perhaps we still can’t do without large monopolistic companies. But for a few decades now we’ve been running an experiment between two uses of our telecommunications infrastructure: The telephone network in which a few large companies are what economists call ”monopolistic competitors”, and the internet, which offers a close approximation to perfect competition. And the results are compelling – and fascinating.

The global phone network and the internet are both built around the need of service providers in the system – a telco such as Telstra or an ISP such as iiNet – to sell their customers access to others on the global network. They typically agree to reciprocal handling of others’ incoming traffic in exchange for others’ handling their outgoing traffic. But even though phone network technology is largely digital, its whole architecture reflects its ”analog” history.

Just as Alexander Graham Bell built it, the phone network must make connections between phones before a call takes place. No connection, no call. And if you’re a service provider seeking access to all the world’s telephone connections, you’ll be negotiating access with some large, tough, global telcos with huge networks to which you need access. Even the legal fees to negotiate and write the contract won’t be cheap. And that’s before any fees are agreed on.

In that world, as digital technology slashes costs, it takes years for monopolistic competitors to pass it on. With long-distance calls and text now much cheaper in most telco packages, the new frontier is outgoing international calls and the still astronomical cost of international roaming – calling on your Australian mobile in overseas markets.

The internet is a different world in which the cost of voice and text and international ”roaming” have all collapsed to pretty much zero. Digital from the start, it works by routing ”data packets”: Each is ”addressed” and makes its own opportunistic way through the net depending on network conditions.

So although the internet is built from the same reciprocal service agreements between service providers, if someone won’t negotiate reasonably, other options are always available. And, since no one’s indispensable, few are tempted to negotiate unreasonably.

And so, miraculously, all those transaction costs between service providers negotiating reciprocal access to each others’ services collapse.

As OECD researchers reported recently, 99.5 per cent of reciprocal access agreements occur informally without written contracts. Paradoxically, as competition becomes more intense or ”perfect”, it becomes indistinguishable from perfect co-operation – a neat trick demonstrated in economists’ models a century ago.

What’s this mean for efficiency and productivity? If internet transit prices were stated in an equivalent voice-per-minute rate, they’d be less than a millionth of a cent per minute – one hundred thousandth of typical voice rates.

And as transaction costs have collapsed in cyberspace, new possibilities, new social and economic formations have burgeoned. It’s an extraordinary world in which anyone – including (crucially) any innovator – can access the network without requiring the permission of monopolistic gatekeepers – as one must with telephone or TV networks, for instance. So any one of the 2 billion people now connected to the net can collaborate with any other.

We already know of the power of Google, Wikipedia, Twitter and open-source software such as Linux. But that’s just the beginning. Healthcare, education, even finance will be revolutionised, though the rate at which it happens will still depend on the extent to which the monopolistic gatekeepers impede the progress of the innovators, the visionaries and the barbarians at the gates.

Postscript: The interview of the column - with Alex Sloan of ABC Radio Canberra.

5 thoughts on “When transactions costs collapse and competition becomes ‘perfect’: the column

  1. So where does the R&D funding come from? – or is the innovation all pro bono, using the Cognitive Surplus (as identified by Clay Shirky).

    When you have grown up in an economic model based on scarcity, rethinking is hard.

  2. Thanks Laurence,

    Great question. I’m not sure of the complete answer but a partial answer is that R&D can go on with ‘normal margins’ where it’s not heroic R&D (in other words real world ‘perfect competition’ is not that perfect.) If R&D will help you deliver packets more cheaply then you get it financed and install the lower cost stuff. Much of this can migrate to the web from other applications.

    But this still leaves the question of how people fund above average service on the net. The answer at present is that sellers of services will pay more – Amazon, Google and so on will invest in additional servers and better service and in the services of Akamai and similar internet infrastructure providers. The paper also suggests that some aspects of innovation have fallen off in internet infrastructure.

  3. Pingback: Four short links: 20 November 2012 - O'Reilly Radar

  4. Spot on. Mobile telcos are racing to get in on the smartphone party but do they see the brewing storm? My friend uses a Samsung Galaxy in Vietnam. 3GB data plan for $9 USD a month. If I call her Vietnam number using Skype it’s around 33 cents a minute in American currency. If we use the free app called LINE or Kakaotalk we can call and text for almost free using data plan or wifi. Multiply that type of scenario country by country.

    As more people use smartphones and more 3g and 4g are built when do the voice call charges reach a tipping point? When does a mobile company just become a collection of “dumb pipes”?

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